What Is an Annuity?
An annuity is an insurance contract issued and distributed by financial institutions and purchased by individuals to provide a steady income stream. The issuer undertakes to pay either a fixed or variable income to the purchaser, beginning immediately or at a future date.
Annuities are primarily used for retirement income purposes to help individuals mitigate the risk of outliving their savings.
Key Takeaways
- Annuities offer a guaranteed income stream and are often bought by retirees.
- The accumulation phase is when investors fund the annuity with lump-sum payments or periodic contributions.
- Payments are made to the annuitant after the annuitization phase, either for a fixed period or their entire life.
- Annuities offer various structures for flexibility, such as immediate or deferred, as well as fixed, variable, or indexed.
How an Annuity Works
Purpose
Annuities are designed to provide steady cash flow during retirement years, which helps in alleviating the fear of outliving one’s assets. These financial products are suitable for individuals looking for stable and guaranteed retirement income. However, given their illiquid nature and withdrawal penalties, younger individuals or those with liquidity needs should avoid them.
Phases
An annuity goes through different phases:
- Accumulation Phase: The time when the annuity is being funded, growing on a tax-deferred basis.
- Annuitization Phase: The payout phase, where payments to the investor begin.
Immediate vs. Deferred Annuities
Annuities can be either immediate or deferred. Immediate annuities start payments soon after they are purchased, suitable for all-age individuals owning a large sum of money. Deferred annuities grow on a tax-deferred basis, offering guaranteed income starting from a specific date in the future.
Regulation
Variable annuities are regulated by the SEC and state insurance commissioners, whereas fixed annuities are overseen by state insurance commissioners alone. Indexed annuities usually fall under similar regulations.
Agents selling annuities must hold a state-issued life insurance license, and in some cases, a securities license. Due to complicated tax considerations, professional consultation is advisable.
Other Considerations
Surrender Period and Withdrawals
Annuities usually impose a surrender period during which withdrawals incur penalties. It’s crucial to evaluate financial needs during this period. Many insurance companies permit up to 10% of account value withdrawals without fees; exceeding this can lead to penalties. There are tax implications for early withdrawals before 59½.
Income Rider
Income riders ensure a fixed income and are accompanied by varying fees depending on the provider. These riders are essential for hedging longevity risk, ensuring stable income regardless of life span.
Annuities in Workplace Retirement Plans
Annuities, while beneficial, are complex and hence not frequently included in employer retirement portfolios. The SECURE Act has eased rules, potentially increasing annuity investments in 401(k) and 403(b) plans.
Types of Annuities
Annuities can provide payments based on different criteria:
- Immediate and Deferred Annuities: Start payments immediately after a lump sum deposit or after a predetermined period, respectively.
- Fixed, Variable, and Indexed Annuities:
- Fixed Annuities: Provide guaranteed interest rates and fixed payments.
- Variable Annuities: Payments vary based on investment performance.
- Indexed Annuities: Returns are based on an equity index, like S&P 500.
While variable annuities entail market risk, adding riders can convert them into hybrid versions offering both growth potential and minimum guaranteed withdrawals.
Criticism of Annuities
Annuities can be illiquid, complicated, and often involve surrender fees. Prospective buyers must understand the involved fees, penalties, and complexities.
Annuities vs. Life Insurance
Life Insurance
Life insurance and annuities are commonly offered by financial institutions as they balance each other’s risks. Life insurance addresses mortality risk by paying out a death benefit to beneficiaries.
Annuities
Annuities handle longevity risk, offering income for one’s lifetime, which the issuer hedges by balancing with higher-risk individuals.
Examples of an Annuity
- Fixed Annuity: Regular monthly payments in retirement after a fixed payment period.
- Immediate Annuity: Regular immediate payments post a lump sum investment.
Who Buys Annuities?
Annuities suit individuals needing stable, guaranteed income streams during retirement. Given their illiquid nature and withdrawal penalties, they are better for long-term financial security planning.
What Is a Non-Qualified Annuity?
Non-qualified annuities are bought with after-tax dollars and only their earnings are taxed upon withdrawal, unlike qualified annuities bought with pre-tax dollars.
What Is an Annuity Fund?
An annuity fund is an investment comprised of various financial assets affecting the annuitant’s payouts.
What Is the Surrender Period?
The surrender period is the mandatory timeframe for holding an annuity before withdrawals can be made without penalty.
The Bottom Line
An annuity is a contract ensuring a steady income stream, either fixed, variable, or indexed, in exchange for one-time or regular payments. Discussing this complex yet beneficial financial product with a professional is advisable for tailored advice.
Related Terms: life insurance, guaranteed income, retirement savings, financial security, investment.
References
- Annuity.org. “Annuities”.
- FINRA. “Annuities.”
- U.S. Securities and Exchange Commission. “Surrender Charge”.
- Annuity.org. “Withdrawing Money from an Annuity”.
- Annuity.org. “Selling Annuity FAQs”.
- U.S. Congress. “H.R. 1994 - Setting Every Community Up for Retirement Enhancement Act of 2019”.
- Approach FP. “Do You Get Your Principal Back From an Annuity? It Depends”.
- U.S. Securities and Exchange Commission. “Annuities”.
- Internal Revenue Service. “Publication 575, Pension and Annuity Income”.
- Internal Revenue Service. “Part 1 Section 1035 – Certain Exchanges of Insurance Policies”.
